The Five Pillars of Tax Planning

Tax planning can involve many different strategies.  To understand the different options available to you, it’s important to understand what I call the five pillars of tax planning.  Below you will find the pillars that every tax planning strategy comes from.

Accelerated Deductions

 To understand this pillar, it’s important to understand how tax brackets work.  Many people ask me the question, “will that put me in a higher tax bracket?”  Some people believe, incorrectly, that if you move into a higher tax bracket, that all of your income is taxed at that higher rate.  This is not the case.  The tax brackets work so that only the amount of income over that bracket is taxed at the higher rate.  So if the next bracket starts at $100,000, and your income is $110,000, only the $10,000 over the bracket is taxed at the higher rate.  Sometimes, if a client has adequate cash, it may make sense to pay for expenses in advance of when they normally would.  Perhaps you can stock up on supplies in late December instead of early January.  By getting this deduction for the current year instead of waiting until the next, you get the benefit of the deduction sooner.  A December expense is beneficial for reducing the taxes due in the following April, whereas, an expense in January doesn’t give the benefit of a deduction until the following April when that year’s taxes are due.  This pillar is all about getting the deduction sooner versus later.  It is important to not get carried away with this strategy.  Taxpayer’s should only buy things that they will eventually need, otherwise they are spending money for no reason.  It is much better to keep your $1 than to spend it to have your taxes lower by $0.35.

Deferred Income

This pillar is the opposite of accelerated deductions.  It involves moving your income to a later year when you can.  This pillar does not have as much flexibility as the others.  Most small businesses operate on the cash basis, meaning they only pay tax on income when cash is received.  Meaning that if a taxpayer sends out a bill, and they are cash basis, they pay tax when the customer pays that bill.  Conversely, an accrual basis taxpayer pays the tax when the bill is generated and sent to the customer. Deferring income involves structuring agreements so that payment is received at a later date.  The IRS requires that you pay tax on income that is “constructively received.” The IRS does not allow you to simply not deposit a check until January even though you received it in December.  The payment is included in income for the year it is received.  Not the year it is deposited.  Taxpayers have gotten into trouble by thinking they can wait to deposit checks and be able to wait to include that cash in income until the next year.

Retirement Contributions

 In our opinion, this is the best type of tax planning.  Most retirement plans allow you a deduction when you contribute money to them.  This is a unique strategy because it allows you to move money from one pocket to another and get a deduction for it.  This strategy can also provide for more flexibility because some retirement plans allow you to make the contribution after the tax year has ended.  Every retirement plan has different rules in regards to how much you can contribute and the way those contributions are made.  A good CPA will be able to help you navigate through these issues and help you choose the right plan.

Equipment

 The Tax Cuts and Jobs Act (TCJA) made huge changes to how large purchases are treated in the tax code.  Previously, large purchases like vehicles and equipment had to be depreciated over a number of years.  The TCJA allows many taxpayers to deduct large purchases like this all in one year.  This means that a taxpayer who buys a new work vehicle for $50,000 can deduct the entire cost of that vehicle in one year.  An especially convenient thing about this strategy is that you are able to finance many of these purchases.  So you may be able to buy a $50,000 vehicle while only putting down a $10,000 down payment.  This way, you get a $50,000 deduction with only a $10,000 cash outlay.  It’s important to remember though, that in the following years you will continue to have to make loan payments but will have already used your deduction.  So in future years you’ll have a cash outlay without any deduction other than interest expense (principal payments on loans aren’t deductible).  This strategy comes with a disclaimer, I see so many people fall into the trap of thinking they need to buy something every year to avoid tax.  They may start buying equipment that they don’t need simply to avoid tax.  This can lead to a lot of equipment on hand that is losing value and a lot of loan payments to make.  You should only purchase equipment if you will actually need it within the next 18 months.  If your tax bracket is 22% and you buy a $10,000 piece of equipment that you don’t need, you’re spending $10,000 for $2,200 in tax savings which isn’t a good return on investment if you don’t actually need that piece of equipment.  Also, be sure to talk to a qualified CPA who can make sure you are able to take advantage of these deductions.  There are different qualifications for taking advantage of these deductions.  Don’t make a large purchase without talking to someone who can make sure you’ll get the benefit you are looking for.

Shifting of Expenses

 The final pillar involves deducting expenses that you might already be paying for but that you don’t know are a deduction.  The first one that comes to mind for me is health insurance.  For small business owners, you are already likely paying for health insurance unless a spouse has a plan through work.  This is an expense that a small business can deduct.  Be careful, however, because an employer is not allowed to pay for and deduct a benefit like this without also providing it to employees.  A qualified CPA can help you navigate these rules to see if you are able to deduct those expenses.  Some expenses may have a dual personal and business purpose to them.  In this case, we can arrive at a reasonable business portion of that expense and only deduct that portion.

Every tax strategy is rooted in one of these pillars.  Understanding each of them and knowing when to utilize each of them will ensure that you take advantage of the tax code where you can.

Any federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (i) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer, or (ii) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein. Thus, each taxpayer should seek specific tax advice based on the taxpayer’s particular circumstances from an independent tax advisor.

Disclaimer:

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties. If desired, Tax Professionals P.C.  would be pleased to perform the requisite research and provide you with a detailed written analysis. Such an engagement may be the subject of a separate engagement letter that would define the scope and limits of the desired consultation services.